9/22/2018. Chapter 5. Preview. Learning Objectives. The Behavior of Interest Rates

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1 Chapter 5 The Behavior of Interet Rate Preview In thi chapter, we examine how the overall level of nominal interet rate i etermine an which factor influence their behavior. Learning Objective Ientify the factor that affect the eman for aet. Draw the eman an upply curve for the bon market, an ientify the equilibrium interet rate. Decribe the connection between the bon market an the money market through the liquiity preference framework. Lit an ecribe the factor that affect the money market an the equilibrium interet rate

2 Determinant of Aet Deman Wealth: the total reource owne by the iniviual, incluing all aet Expecte Return: the return expecte over the next perio on one aet relative to alternative aet Rik: the egree of uncertainty aociate with the return on one aet relative to alternative aet Liquiity: the eae an pee with which an aet can be turne into cah relative to alternative aet Theory of Portfolio Choice Holing all other factor contant:. The quantity emane of an aet i poitively relate to wealth. The quantity emane of an aet i poitively relate to it expecte return relative to alternative aet 3. The quantity emane of an aet i negatively relate to the rik of it return relative to alternative aet 4. The quantity emane of an aet i poitively relate to it liquiity relative to alternative aet Theory of Portfolio Choice

3 Supply an Deman in the Bon Market At lower price (higher interet rate), ceteri paribu, the quantity emane of bon i higher: an invere relationhip At lower price (higher interet rate), ceteri paribu, the quantity upplie of bon i lower: a poitive relationhip Supply an Deman for Bon Price of Bon, P ($),000 (i = 0%) B With exce upply, the 950 (i = 5.3%) A I bon price fall to P * 900 (i =.%) B C H P * = 850 (i * = 7.6%) 800 (i = 5.0%) G D 750 (i = 33.0%) F E With exce eman, the bon price rie to P * B Quantity of Bon, B ($ billion) Market Equilibrium Occur when the amount that people are willing to buy (eman) equal the amount that people are willing to ell (upply) at a given price. B = B efine the equilibrium (or market clearing) price an interet rate. When B > B, there i exce eman, price will rie an interet rate will fall. When B < B, there i exce upply, price will fall an interet rate will rie. 3

4 Change in Equilibrium Interet Rate Shift in the eman for bon: Wealth: in an economic expanion with growing wealth, the eman curve for bon hift to the right Expecte Return: higher expecte interet rate in the future lower the expecte return for long-term bon, hifting the eman curve to the left Expecte Inflation: an increae in the expecte rate of inflation lower the expecte return for bon, cauing the eman curve to hift to the left Rik: an increae in the rikine of bon caue the eman curve to hift to the left Liquiity: increae liquiity of bon reult in the eman curve hifting right Figure Shift in the Deman Curve for Bon Price of Bon, P A A B An increae in the eman for bon hift the bon eman curve rightwar. B C C D D E B E B Quantity of Bon, B Shift in the Supply of Bon Shift in the upply for bon: Expecte profitability of invetment opportunitie: A the economy expan, the upply curve hift to the right Expecte inflation: an increae in expecte inflation hift the upply curve for bon to the right Government buget: increae buget eficit hift the upply curve to the right 4

5 Figure 3 Shift in the Supply Curve for Bon Price of Bon, P I B B I H H G C C An increae in the upply of bon hift the bon upply curve rightwar. G F F Quantity of Bon, B 5

6 Cae Stuy: Increae in Expecte Rate of Inflation Recall expecte inflation affect both bon upply an bon eman. Increaing expecte inflation Reuce the real cot of borrowing hifting bon upply to the right. But, lower real return on lening (alo poible capital lo), hifting bon eman to the left What happen to bon price an interet rate? Repone to a Change in Expecte Inflation Price of Bon, P B B P Step. A rie in expecte inflation hift the bon eman curve leftwar... Step. an hift the bon upply curve rightwar... Step 3. cauing the price of bon to fall an the equilibrium interet rate to rie. P B B Quantity of Bon, B 6

7 Expecte Inflation an Interet Rate (Three-Month Treaury Bill), Source: Feeral Reerve Bank of St. Loui FRE D atabae: Expecte inflation calculate uing proceure outline in Freeric S. Mihkin, The Real Interet Rate: An Empirical Invetigation, Carnegie-Rocheter Conference Serie on Public Policy 5 (98): Thee proceure involve etimating expecte inflation a a function of pat interet rate, inflation, an time tren. Cae Stuy: Interet Rate an the Buine Cycle A buine cycle ownturn (receion): Reuce buine invetment opportunitie hifting bon upply to the left. Reuce wealth, hifting bon eman to the left alo. In theory, both hift coul give an ambiguou anwer. The ata i not ambiguou. In receion, interet rate ten to fall meaning that bon price rie. Buine Cycle an Interet Rate (Three-Month Treaury Bill),

8 Repone to a Buine Cycle Expanion Price of Bon, P B B Step. A buine cycle expanion hift the bon upply curve rightwar... Step. an hift the bon eman curve rightwar, but by a leer amount... P Step 3. o the price of bon fall an the equilibrium interet rate rie. P B B Quantity of Bon, B The Liquiity Preference Framework Keyneian moel that etermine the equilibrium interet rate in term of the upply of an eman for money. There are two main categorie of aet that people ue to tore their wealth: money an bon. Total wealth in the economy = B M = B + M Rearranging: B - B = M M - - M If the market for money i in equilibrium (M = M ), then the bon market i alo in equilibrium (B = B ). Supply an Deman in the Market for Money: The Liquiity Preference Framework Deman for money in the liquiity preference framework: A the interet rate increae: The opportunity cot of holing money increae The relative expecte return of money ecreae therefore the quantity emane of money ecreae. 8

9 Equilibrium in the Market for Money Interet Rate, i (%) 0 7 A At 7% there i an exce M upply of money. It nee to go omewhere. In the Liquiity Preference framework, it goe into the bon market. 6 B Bon eman increae, the interet rate fall to 5%=i *. i * =5 C At 3% there i an exce eman for money. 4 D In the Liquiity Preference framework, it i met by elling bon. 3 E Bon upply increae, the interet rate rie to 5%=i *. M Quantity of Money, M ($ billion) Change in Equilibrium Interet Rate in the Liquiity Preference Framework Shift in the eman for money: Income Effect: a higher level of income caue the eman for money at each interet rate to increae an the eman curve to hift to the right Price-Level Effect: a rie in the price level caue the eman for money at each interet rate to increae an the eman curve to hift to the right Figure 9 Repone to a Change in Income or the Price Level Interet Rate, i M Step. A rie in income or the price level hift the money eman curve rightwar... i Step. an the equilibrium interet rate rie. i M M M Quantity of Money, M 9

10 Change in Equilibrium Interet Rate in the Liquiity Preference Framework Shift in the upply of money: The upply of money i controlle by the central bank. An increae in the money upply engineere by the Feeral Reerve will hift the upply curve for money to the right. Increaing liquiity in financial market. Repone to a Change in the Money Supply Interet rate, i M M Step. Fe increae the money upply. i i Step. an the equilibrium interet rate fall. Thi i the Liquiity Effect. M Quantity of Money, M Change in Equilibrium Interet Rate in the Liquiity Preference Framework 0

11 Money an Interet Rate A one time increae in the money upply will caue price to rie to a permanently higher level by the en of the year. The interet rate will rie via the increae price. Price-level effect remain even after price have toppe riing. A riing price level will raie interet rate becaue people will expect inflation to be higher over the coure of the year. When the price level top riing, expectation of inflation will return to zero. Expecte-inflation effect perit only a long a the price level continue to rie. Doe a Higher Rate of Growth of the Money Supply Lower Interet Rate? Liquiity preference framework lea to the concluion that an increae in the money upply will lower interet rate becaue of the liquiity effect. Overtime however, the income effect caue interet rate to increae becaue increaing the money upply ha an expanionary influence on the economy (the eman curve hift to the right). Doe a Higher Rate of Growth of the Money Supply Lower Interet Rate? Price-Level effect preict an increae in the money upply lea to a increae in interet rate in repone to the rie in the price level (the eman curve hift to the right). Expecte-Inflation effect how an increae in interet rate becaue an increae in the money upply may lea people to expect a higher price level in the future (the eman curve hift to the right).

12 Money Supply Growth an the Effect on Interet Rate Liquiity Effect: Income Effect: M growth i i Income M i Price Level Effect: Income Price level M i Expecte Inflation Effect: Price level π e B B Fiher effect i Effect of higher money growth on nominal interet rate i ambiguou becaue income, price level an expecte inflation effect work in oppoite irection of liquiity effect Interet Rate, i i Repone over Time to an Increae in Money Supply Growth Interet Rate, i i i i Interet Rate, i T Time Liquiity Income, Price-Level, Effect an Expecteinflation Effect T Time Liquiity Income, Price-Level, Effect an Expecteinflation Effect (a) Liquiity effect larger than other effect (b) Liquiity effect maller than other effect an low ajutment of expecte inflation i i T Liquiity an Income an Priceexpecte- Level Effect inflation Effect Time (c) Liquiity effect maller than expecte-inflation effect an fat ajutment of expecte inflation Money Growth (M, Annual Rate) an Interet Rate (Three- Month Treaury Bill), Source: Feeral Reerve Bank of St. Loui FRE D atabae: